B. Rights in a Unit: A Preliminary Analysis and Three Propositions
A modern trust deed invariably provides that the trustee will hold the unit trust assets for the unitholders ‘on and subject to the terms and conditions of the trust deed‘ and in the case of an authorized unit trust, the regulations made under section 81 of the Financial Services Act 1986.It is always possible for the trust deed or the relevant regulations to contain hundreds of covenants or terms that may alter or add to the rights in the beneficial interests of the trust assets. With the varieties of unit trusts and the varieties of units in the market today, the significance of the qualifying statement ‘on and subject to the terms and conditions of the trust deed‘ may easily be overlooked. Read the rest of this entry »
Pricing
When buying or selling either an open-end or closed-end fund, an investor usually knows the current value of the fund’s assets per share (NAV).
For example, to buy an open-end fund with a NAV of $15, an investor pays $15 per share. The fund simply issues new shares to the investor at the current NAV. The assets the fund manages have increased, but the value per share remains the same because the new shares have exactly the same value as the other shares. If the investor sells, he or she is paid the NAV. The amount of assets the fund manages has been reduced, but the NAV of outstanding shares has not changed because the shares redeemed were equal in value to all others.
With closed-end funds, the shares are traded in the open market and are consequently subject to demand/supply imbalances. They may trade at a price greater than their NAV (termed a premium) or at a price below the NAV (termed a discount). Read the rest of this entry »
All freely traded liquid markets share common traits related to psychological pressures (fear and greed), but each differs as to fundamental relationships, trading mechanisms, and structural factors. Each market’s individual characteristics must be understood. Once this understanding has been achieved, proper evaluation of similarities or differences, as well as interrelated pricing effects, with other markets can be accomplished.
One market that allows easy application of Drach’s common stock analysis is closed-end funds, also known as publicly traded funds or closed-end investment trusts (CEITs).
Although one of the oldest forms of investment, closed-end funds are among the most misunderstood and consequently often overlooked investment areas. Their origin can be traced back to the establishment of a Belgian fund in 1822; thereafter they flourished, particularly among English and Scottish investors in the latter 1800s. The first U.S. fund was formed in 1893 and, until the time of the stock market crash of 1929, closed-end funds were the dominant form of publically owned investment companies. Read the rest of this entry »
In both the primary and many of the ancillary criteria that determine buy/sell signals, interest rate projections play an important role. Whenstocks are priced at reasonable or discounted levels relative to historical fundamental norms, lowering interest rates can have a strong positive effect. Conversely, especially when stocks are overvalued relative to fundamentals, higher interest rates can be shown to have a very negative effecton stock pricing.
The effect on bonds (and bond funds) resulting from interest rate changes are more straightforward than stock pricing relationships because the effect on stocks at any given time depends on stock price levels. The effect on bonds is direct: Lower rates create higher bond prices, and higher rates result in lower bond prices. The effect of rate changes on bond prices can be more dramatic than many investors realize, with the greater price shifts associated with longer maturities. Read the rest of this entry »
In the published common stock portfolio modeling the Continuous Full Investment portfolio models were included to function as a control to allow objective comparisons with the market timing models.
Although intended as a control, allowing demonstration of the validity of the timing technique, the Continuous Models have significantly outperformed the broadly based popularized market averages. The reasons for this superior performance are twofold. First, the rigid requirements for stocks to qualify for the Master List results in the stocks comprising the Continuous Models to be of usually superior fundamental quality, thereby giving the group an upward bias relative to the overall market. Second, the Continuous Models change positions in a gradual, relatively slow process in which new positions are selected that are among the most discounted (low-priced relative to the others) on the list. In effect, a rotational process adds those that have become more discounted and deletes those less discounted. Read the rest of this entry »
Two things must be kept in mind when establishing a long position in this kind of hedge. First, since Treasury bond futures contractsrepresent face value of $100,000 worth of Treasury bonds, the investor will want to go long approximately $100,000 worth of closed-end bondfunds. When it comes to trading closed-end bond funds, I do not recommend buying more than 2000 or 3000 shares of a single fund for a short-term trade. That is why we would go long several different closed-end funds, representing positions of from $31,000 to $34,000 and amounting to approximately $100,000. That $100,000 long position offset the short position of 1 September U.S. Treasury bond futures contract at 100.18, priced at a 7.943 yield.
On February 10, 1978, with the Dow Jones Bond Average down to 89.79, two significant changes had taken place since we established our theoretical long and short positions: (1) The long positions in the bond funds had become profitable, and (2) so had the short position in the Treasury bond futures contract. For example, JHS was selling at 175/8, up from 167A; DBF was up to 165/8 from 161/2; and PAI had gone from 135/8 to 1334. The net asset values of all three funds had declined but the discounts, as predicted, narrowed more than the decline in net asset values, resulting in the profits. Read the rest of this entry »
In the common stock investment techniques, the most obvious hedging strategy might be to be long the stocks that are relatively discounted and sell short those that appear most overpriced. However, the process is not so simple.
Because of the composition of the Master List, the stocks as a group tend to do significantly better than the market as a whole. Consequently, although the long positions have significantly outperformed the broadly based market, the short positions, if sold, will likely provide lesser returns than the overall market.
It is because of the Master List’s positive bias that in hedging accounts Drach utilizes writing index call options as a substitute for the short side. This substitution both eliminates the effect of the Master List’s upside bias that would be experienced in attempting to short Master List stocks and provides added profitability for the short side because of premium capture. As discussed in Chap. 9, the method of going long the selected Master List issues and proportionately shorting (selling) index call options is a lethargic process, which has so far produced a constant annualized return of about 15 percent irrespective of overall market conditions. Read the rest of this entry »
Let’s illustrate the mechanics of a standard single-name credit default swap. Assume that the reference entity is the ABC Corporation and the reference obligation is the ABC Subordinated Debenture due 2110. The swap premium—the payment made by the protection buyer to the protection seller —is 550 basis points. If a credit event occurs, the protection seller pays the protection buyer the notional amount of the contract. In our illustration, we will assume that the notional amount is $10 million.
The notional amount is not the par value of the reference obligation. For example, suppose that a bond issue is trading at 73.53 (par value being 100). If a portfolio manager owns $13.6 million par value of the bond issue and wants to protect the current market value of $10 million (approximately equal to 73.53% of $13.6 million), then the portfolio manager will want a $10 million notional amount. If a credit event occurs, the portfolio manager will deliver the $13.6 million par value of the bond and receive a cash payment of $10 million. Read the rest of this entry »
Valuing Caps and Floors
The arbitrage-free binomial model can be used to value a cap and a floor. This is because, as previously explained, a cap and a floor are nothing more than a package or strip of options. More specifically, they are a strip of European options on interest rates. Thus to value a cap the value of each period’s cap, called a caplet, is found and all the caplets are then summed. The same can be done for a floor.
To illustrate how this is done, we will once again use the binomial interest-rate tree to value an interest rate option. Consider first a 5.2%, three-year cap with a notional amount of $10 million. The reference rate is the one-year rates in the binomial tree. The payoff for the cap is annual.
Exhibit 25-12 shows how this cap is valued by valuing the three caplets. The value for the caplet for any year, say year X, is found as follows. First, calculate the payoff in year X at each node as either zero if the one-year rate at the node is less than or equal to 5.2%, or the notional principal amount of $10 million times the difference between the one-year rate at the node and 5.2% if the one-year rate at the node is greater than 5.2%
Then, the backward induction method is used to determine the value of the year X caplet. Read the rest of this entry »
Once the swap transaction is completed, changes in market interest rates will change the payments of the floating-rate side of the swap. The value of an interest rate swap is the difference between the present value of the payments of the two sides of the swap. The three-month LIBOR forward rates from the current Eurodollar CD futures contracts are used to (1) calculate the floating-rate payments and (2) determine the discount factors at which to calculate the present value of the payments.
To illustrate this, consider the three-year swap used to demonstrate how to calculate the swap rate. Suppose that one year later, interest rates change as shown in Columns (4) and (6) in Exhibit 25-9. Column (4) shows the current three-month LIBOR. In Column (5) are the Eurodollar CD futures prices for each period. These rates are used to compute the forward rates in Column (6). Note that the interest rates have increased one year later since the rates in Exhibit 25-9 . Read the rest of this entry »
A total return swap in the fixed-income market is a swap in which one party makes periodic floating-rate payments to a counterparty in exchange for the total return realized on a reference obligation or a basket of reference obligations. A total return payment includes all cash flows that flow from the reference obligations as well as the capital appreciation or depreciation of those reference obligations. When the reference obligation is a bond market index, the swap is referred to as a total return index swap.
The party that agrees to make the floating payments and receive the total return is referred to as the total return receiver; the party that agrees to receive the floating payments and pay the total return is referred to as the total return payer.
Notice that in a total return swap, the total return receiver is exposed to both credit risk and interest-rate risk. For example, the credit risk spread can decline (resulting in a favorable price movement for the reference obligation), but this gain can be offset by a rise in the level of interest rates. Read the rest of this entry »
Finally, the structure of the currency markets may work against elimination of the forward rate bias. Note that the forward rates depend only on the spot rate and the difference in interest rates. For arbitrage reasons, the forward rate cannot depend on anything else (see the discussion of interest rate parity in “Description,” above). However, an exchange rate between two currencies reflects the relative state of the two economies. If the U.S. economy is expected to do better than the Japanese economy, then the spot exchange rate will reflect that. Any changes in growth expectations will promptly cause a change in the spot exchange rate and thereby in the forward exchange rate. For example, the dollar strengthened from 1995 to 2000 because of the relative strength of the U.S. economy. During 2002 and early part of 2003, when expectations about U.S. economic growth were constantly revised downward, the dollar kept losing ground to other currencies. Read the rest of this entry »
Empirical evidence suggests that stocks experience momentum and reversals in returns depending on holding periods. Generally, there is momentum in short-term returns of about one month and also in the medium term of about one year, but reversals in longer periods of three to five years.
The most successful momentum strategy is to buy stocks that have performed the best over the past three to twelve months, and short-sell stocks that performed the worst over the same period. If these positions are held for the next three to twelve months, the positions generate an abnormal return of about 12 percent per year. Momentum strategies seem to be adopted extensively by mutual funds and other institutions.
Over longer periods, studies find that the returns reverse, that is, past winners become losers if held for three to five years and past losers become winners. According to long-term studies, 25-40 percent of the future return is predictable based on past returns.
Unlocking Value Around Expiration of IPO Lockups
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There are many mispricings that have been discovered by academic and practitioner research that have not been discussed in previous articles. While it is not possible to list all possible anomalies and nonanomalies, a few popular or interesting anomalies are listed below, with a brief description relating to that anomaly. The following features characterize the mispricings selected for inclusion:
- The mispricing has been tested with different sample periods and different methods. Some popular mispricings that are not supported by the evidence are also included so that readers can see examples of failed anomalies.
- The mispricing appears interesting and profitable though more testing is warranted.
Several long-term mispricings are included because there is much evidence to support the mispricing even though it is prudent to remain skeptical of long-term underperformance or overperformance for reasons. Read the rest of this entry »
Client research by Benefits, Inc. shows that plan participants may be usefully grouped into three major segments based on their attitudes toward, and sophistication with, investment concepts. Plan sponsors should consider positioning options to relate to the needs of each segment.
Insecure investors usually compose the largest single participant group. These individuals describe themselves as “beginner” investors. They express a lack of confidence and understanding in matters related to investing and doubt their ability to accumulate enough assets to retire. Their lack of confidence has pushed them into relatively safe investment choices such as money market, fixed income and stable value options. They tend to be the least well diversified. Some avoid participating in a 401(k) plan altogether because of their lack of confidence. Read the rest of this entry »
The pricing and bookkeeping agent is responsible for maintaining the fund’s accounting records, pricing the fund’s portfolio each day, calculating periodic distributions, determining the fund’s cash availability, preparing financial statements and filing the fund’s tax returns. A fund’s accounting records are very similar to those of a small corporation, consisting of revenue, expenses, assets, liabilities and shareholder’s equity. The pricing and bookkeeping agent is responsible for maintaining these records each day. The accounting records are the basis for calculating the fund’s NAV, the price at which shareholders buy into and sell out of the fund, as well as for determining the distributions the fund makes to its shareholders. Read the rest of this entry »
Back-end loads are a sales commission levied by some load funds when an investor sells mutual fund shares. These back-end loads typically are structured as a contingent deferred sales charge (CDSC), which often start at 5% or 6% of money withdrawn within a year of buying the fund and then decline by a percentage point or so each year until they disappear. Back-end loads usually are set to compensate the distributor for marketing and selling the fund, especially to protect anticipated annual flows of 12b-1 fees. However, back-end loads may also be used to dissuade short-term traders; funds may set a high back-end load for money withdrawn within a very short time frame and then revert to the more general schedule of yearly declining load amounts referenced above. Read the rest of this entry »
In reviewing the expenses of mutual fund investors, it is useful to distinguish between expenses paid directly by shareholders as individual investors and expenses paid by the fund itself (which are paid indirectly by all fund shareholders). In general, fees related to distribution and redemption are paid by shareholders at the time of a specific event, while fees related to management and service are paid by the fund on an annual basis. But this general rule has a few exceptions—most important, 12b-1 fees, which are continuing distribution charges borne by funds as a percentage of their assets.
Sales loads are the most significant fees charged to shareholders individually. Sales loads are paid to the fund distributor, usually affiliated with the fund management company, and mostly passed on to the broker who helped close the sale. The maximum sales load is 81A%, though as a practical matter, sales loads now average 4% or 5%. Historically, all sales loads were paid by shareholders when purchasing fund shares at the front end of their investment and therefore were called front-end loads. Read the rest of this entry »
Delta The speed of a Straddle’s position accelerates dramatically Near the Money. Delta is
negative when the stock price is very low and accelerates into,a positive value when the stock price is nearer and above the strike price. This shows us that when the stock price is lower than the strike price, further down movement is profitable, and when the stock price is higher than the strike price, continued up movement is required from the stock to make the Straddle profitable. Delta’s profile is somewhat “S’ shaped. Delta will generally be less than one (for one contract) when the stock price is ATM. This signifies that at that point, the value of the Straddle will vary with the stock price, but at a reduced speed.
Gamma Gamma is always positive with a long Straddle and peaks where delta is rising at its
steepest angle. This invariably occurs Near the Money, indicating that the Straddle is very sensitive to swings in the stock price at these levels.
Theta Time decay affects the Straddle detrimentally. Theta assumes a “V” shape and is almost
entirely negative, forming its trough At the Money. This makes total sense because with a long Straddle you are buying two options premiums and are heavily exposed to time decay. Where the stock price is far lower than the Straddle strike price, theta can have a fractional positive value.
Vega Vega is entirely positive and forms a mountain-top shape, peaking At the Money. With the
vega value peaking ATM this indicates to us that a small increase in volatility is going to increase the value of our Straddle position markedly. Read the rest of this entry »
Valuation
The value of a mutual fund depends on the prices or values of the underlying securities and other assets held by the fund. The manager must carry out regular valuations of the fund’s property, so that the prices at Which shares or units may be bought and sold can be calculated. Regulations usually prescribe how often Valuations must be performed. In the UK, for example, the required minimum frequency is twice each month The majority of funds are valued on a daily basis, but some managers prefer a weekly valuation, and some carry out more than one each day. Read the rest of this entry »
